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Presented by : Vineeth. K
Risk
Risk exists because of the inability of the
decision-maker to make perfect forecasts. In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment. Three broad categories of the events influencing the investment forecasts:
General economic conditions Industry factors Company factors
the concept that investors demands higher returns from the risky projects. The required rate of return on any investment should include: compensation for delaying consumption equal to risk free rate of
higher than risk involved in a similar kind of project, Risk-adjusted rate is rate, will allow upward in order to risk discount discount adjusted for both time preference and preference and will be a sum of the risk-free rate and the risk-premium rate compensate this additional risk borne. reflecting the investors attitude towards risk.
Discount Rate
discount rate used is
greater than risk of existing investments of firm. If risk of project is equal to the risk of existing investments of firm. If risk of project is less than the risk of existing investments
higher than the average cost of capital. discount rate used is equal to the average cost of capital. discount rate used is less than the average cost of capital
rk = i + n + dk
Where,
i - risk free rate of interest. n - adjustment for firm's normal risk.
the project under consideration compares with existing risk of firms. Adjustment for different risk of project 'k' depends on managements perception of project risk and managements attitude towards risk (risk - return
Example:
A company engaged in manufacturing of toys is
considering a line of stationary items with an expected life of five years. From past experience the company has a conservative view in its investment in new products. Accordingly company considers the stationary items an abnormally risky project. The companys management is of view that normally required rate of return of 10% will not be sufficient and hence minimum required rate of return should be 15%. The initial investment in the project will be of Rs. 1,10,00,000 and expected free cash flows to be generated from the project is Rs. 30,00,000 for 5 years. Determine whether project should be accepted or not
Answer
PV of cash inflows
(15%, 5)
= Rs. 30,00,000 x 3.352 = Rs. 1,00,56,000 = Initial investment PV of Cash
NPV
Inflow = 1,10,00,000 1,00,56,000 = Rs. 9,44,000 Thus project should not be accepted.
Contd..
Had the required rate of return be 10%. The position
would have been as follows. PV of Cash Inflows = Rs. 30, 00,000 x PVIAF (10%, 5) = Rs. 30, 00,000 x 3.791 = Rs. 1, 13, 73,000 NPV = Rs. 1,13,73,000 Rs. 1,10,00,000 = Rs. 3, 73,000